Canva co-founders Cameron Adams, Cliff Obrecht and Melanie Perkins.

Worldwide funds under management across private credit, equity, hedge funds, infrastructure, real estate and venture capital has surged from US$3 trillion ($4.6 trillion) in 2010 to about US$14 trillion today, according to UK-based investment consultant Prequin.

Professional and retail investors are boosting allocations to secure the diversification benefits and potential healthy returns offered by assets that seek to provide attractive absolute returns in all markets. And institutional investors, including public-offer pension funds, have been among the drivers of that demand.

The Oregon Public Employees Retirement Fund, for example, had a 27.8 per cent allocation to private equity on June 30. This was 10.7 percentage points more than its allocation to ‘public equity’. In Australia, the Future Fund last week said it would increase its allocation to early-stage companies. The Hostplus Balanced (MySuper) default option holds about 40 per cent in ‘unlisted assets’, having held as much as 51 per cent last year.

The most high-profile of those allocations has been to graphic design software company Canva.

The Australian tech darling, which funds including Hostplus and AustralianSuper invested in either directly or via external venture capital managers such as Blackbird, has captured the attention of mainstream newspapers and regulators.

The Australian Prudential Regulation Authority took the unusual decision to conduct a specific review of funds’ investments in Canva. Its damning conclusion, released yesterday, was that funds were too slow to mark the value of their investments in Canva down, even as its VC and other institutional investors had done so (and in the case of Franklin Templeton by about half of its $US40 billion investment at the cycle’s peak in 2021).

That review follows APRA’s comments in July that it expects unlisted assets to be valued quarterly. Super funds can do this annually now.

The heightened focus from regulators adds weight to the view that the increased exposure of the investment option to retail investors, whether within a super option, via a platform selection or as a ‘wholesale’ investor, warrants greater checks.

Harsh face of capitalism

These agencies will seek to protect people from risks they might not understand or know. Are retail investors aware, for instance, that their money might be tied up? Even property funds, a private equity option so familiar it’s often not considered as such, have gated redemptions (for good reason).

Another trigger for greater scrutiny is private equity’s reputation as a harsh face of capitalism. Private equity companies are known for earning high fees and huge performance bonuses (‘carried interest’ on which they pay low personal taxes in the US), while investing little of their own money and relying on asset sales, cost-cutting, debt, financial engineering and legal manoeuvring to prime assets for sale.

The recent spate of household names moving under private equity ownership has added fuel to the fire.

Subway’s family owners in August sold the US’s biggest fast-food chain by store numbers to US-based private equity firm Roark Capital. The reported US$9.6 billion transaction will add to Roark’s portfolio of food franchises that includes Subway rival Jimmy John’s.

The Subway sale comes shortly after another US-based private equity firm KKR paid US$1.6 billion for Simon & Schuster, a publisher founded in New York City in 1924. And there are many others.

These transactions have also provoked reminders about the bankruptcies of brands such as Sears and Toys “R” Us once under such ownership.

Such failures blamed on ‘plundering’ prompted US Democrats in 2019 to introduce The Stop Wall Street Looting Act. This never-legislated effort aimed to penetrate the liability shield between private equity firms and the companies they buy, to give creditors recourse to recover debt from Wall Street dealmakers.

A third reason for heightened scrutiny is that the popularity of private credit is stirring pushback from rival lenders and fanning concerns among regulators. Banks, at a time when they are facing stricter capital controls, are unhappy they are being disintermediated by asset managers that face no such restrictions.

Regulators are pondering how unsupervised lending will fare during downturns and what it might mean for the effectiveness of monetary policy. Banking regulators have hinted at stricter oversight of the riskiest parts of corporate debt. They have spoken of moving the regulatory focus from key institutions to key ‘activities’ to reaction to the taste private equity firms have for derivatives and debt.

Unsolvable problem

To offer a fourth reason for heightened scrutiny, regulators are also pondering what risks investors might be taking when chasing higher returns with private assets. The unsolvable problem is that such investments only trade sporadically. They are thus illiquid and lack widely accepted prevailing market values.

The big concern is the infrequent ‘independent’ valuation of private assets by accountants – who are conflicted in that they are paid by those seeking favourable outcomes – means risks and losses might be underestimated.

The issue has intensified since commercial-property valuations slumped in the past year or so due to higher interest rates and the shift to work from home. Regulators must guard against excessive valuations because they mean new investors are being short-changed, which is part of APRA’s rationale for its focus in this area.

Amid all this, the key question for super funds and other investors is: what does greater scrutiny of private investments mean for asset allocation?

Three issues stand out that could reduce the attractiveness of the option. One is heightened regulatory and legal risks. Regulators are sure to impose harsher interpretations on private equity. In the US, private equity lobbying and political donations are unlikely to block forever laws that remove its advantages.

Another issue is that business risk is likely to be incorporated into investment decisions. The business sides of super funds, for instance, might prefer to avoid holding contentious private assets. The third issue is that controversies stemming from greater scrutiny might prompt institutional and retail investors to pull back from investing in private assets. The rosy growth forecasts attached to private equity might prove to be optimistic.

To be sure, private equity has always borne scrutiny and most private equity projects will withstand greater inspection. Any heightened scrutiny will be far below what listed companies bear. Private equity has other growth challenges including fewer opportunities if economies slow and capacity constraints.

Even so, greater scrutiny will be new and will only intensify. Private asset owners will learn that success often comes with almost inbuilt impediments to future success.

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